6/20/2008 @ 1:00PM

The Hard Truths About Global Supply Chains

Procurement, historically an uncelebrated topic among business strategists, is now taking center stage. These days, purchasing departments are playing pivotal roles within global firms in ways old-fashioned purchasing managers could never have imagined.

Marshall L. Fisher, director of Wharton’s Fishman-Davidson Center for Service and Operations Management, has been researching issues related to retail supply-chain strategy for many years. In this interview, Fisher highlights some of the challenges global procurement faces, and discusses the example of Luen Thai, a Chinese company that built a giant “supply-chain city,” becoming a one-stop shop for clothing manufacturers looking to outsource to low-cost producers.

Knowledge@Wharton: Before we began recording our conversation, you were talking about some of the interesting and far-reaching changes that have occurred in the area of procurement in the last 10 or 20 years. Can you tell our listeners a little about that?

Fisher: I’d be happy to. My knowledge on this is based on working with a number of U.S.-based product companies on supply-chain strategy, and I’ve been struck by two phenomenons: outsourcing and offshoring of their manufacturing operations.

In the 1980s, thinking back a couple of decades, there was a pretty vigorous debate within the U.S. about the need to strengthen and preserve U.S. manufacturing. This is a time when the Japanese economy was in its ascendancy, and it was believed that was due to their prowess in manufacturing. The belief was that you couldn’t have a viable economy, particularly the U.S. economy, without strong manufacturing. So the message was: Keep manufacturing in the U.S. and make it stronger.

Boy, things have changed a lot in the last two decades. Most companies now are outsourcing and offshoring manufacturing vigorously, almost to the point where you will find companies that don’t make anything themselves or in the United States. It’s going to low-labor-cost regions, predominantly Asia, Eastern Europe and Latin America, and, within Asia, predominantly China.

I wrote a case on a very interesting Chinese company called Luen Thai, based in southern China. They’re the largest private-label apparel manufacturer, so they make for large retailers [like]
Gap
, Limited,
Dillard’s
, or branded apparel companies like
Liz Claiborne
in the United States and some European companies.

And they’ve done a phenomenal thing: They’ve set up this “supply-chain city,” which is a massive facility, probably the largest apparel production facility in the world, intending to leverage a change in trade regulations that happened Jan. 1, 2005.

Prior to that, apparel production was heavily regulated. There were quotas as to how much any country could export to the United States by various categories of apparel, which caused apparel to be spread all over the world. But basically, [it was] a fragmented supply chain with production in lots of different countries because no one country had enough quotas to supply the industry needs.

That quota system was ostensibly eliminated Jan. 1, 2005. And if you look at other categories, say toys [or] consumer electronics, where there is no quota, you’ll see something like 80% to 90% of the production coming out of China. So Luen Thai believes that’s going to happen in apparel and they set up this giant supply-chain city to leverage that.

Knowledge@Wharton: Now, this giant city that you’ve mentioned, that’s very interesting because that was a step that Luen Thai took after looking at the landscape for world manufacturing and coming to a certain set of decisions as to how it was going to respond to these changes. What sorts of challenges has Luen Thai faced, and what have they done, in addition to building this large city for its workers and its production? What sorts of things has Luen Thai done, and what kind of takeaways might there be for our listeners who want to learn more about the way a giant Chinese company goes about doing its business in this kind of environment?

Fisher: Well, some of their challenges are perhaps unique to apparel. So in that category there’s a lot of political pressure to continue some form of restriction on apparel imports. There’s a provision called “safeguards” that limit [and] that kind of put back quotas to some extent.

That lesson is less transferable to other cross segments where you don’t have those same restrictions, such as toys and consumer electronics. The other thing they have been struggling with, which might translate to other industries, is essentially, what’s the best place to locate various functions? So you think about all the steps involved in sizing up a market, designing a product and then producing that product. What gets located where?

So Luen Thai’s original vision is: “We’ll do it all in China. We’ll do design in China. It’ll be one-stop shopping for apparel buyers. So they’ll fly over, we’ll give them really nice offices, just like their offices back at home, and we can quickly design a garment, make a prototype, get that critiqued by the buyers, and redesign it within a few hours.” This is a process that used to take a few weeks to go around that iteration loop.

What they found out is that total outsourcing from original conception of the design of a product through production and delivery to the store–they call it design-to-store–doesn’t work. Why? No. 1, designers don’t want to live in southern China. They want to live in the fashion capitals [like] Manhattan.

Knowledge@Wharton: Sure.

Fisher: So it’s hard to get creative people to go there. The Chinese are turning out their own designers, but they don’t have the reputation and probably not the skill of U.S. designers. And then secondly, it helps a lot to be close to the market. So they’ve been evolving close to the market you’re designing for, to understand the end consumer. So they’ve been refining that concept and their thought is that there’s a … customer-facing aspect of design. In apparel, what’s the artistic look of the garment that would appeal to a particular customer’s look and feel?

And then there’s a production-facing design. For example, a garment is a three-dimensional object made from two-dimensional pieces of cloth. So there’s an engineering function called pattern making that translates that three-dimensional object into a series of two-dimensional shapes cut out of cloth. That engineering-production-type step could be done in China with an interface between them.

So as supply chains become global, companies need to think about what they put where and how they coordinate across those various functions.

Knowledge@Wharton: And in the case of Luen Thai Holdings, that was a major decision, was it not?

Fisher: It was absolutely a big bet. They’re a fairly old company, and they had thrived under the old quota system. One of their people joked that if you had a sewing factory and owned quota, which is the right to export to the United States or Europe, it was like a license to print money. And we printed a lot of money. But [after] Jan. 1, 2005, that quota system was going to go away, so their license was about to be revoked.

And several years prior to that, they started thinking, “Life is good, but we can’t continue in that old way because this elimination of quota is going to change things, so we need to have a plan.” And this was their answer.

Knowledge@Wharton: Now, did Luen Thai have any difficulty convincing its customers in North America and Europe and elsewhere that this “design-to-store” concept would work for them?

Fisher: Absolutely, because apparel buying is highly cost-driven. Why? Cost is very visible, so a buyer knows whether or not they’re getting the lowest cost. If they pay a higher cost, but they get additional service, well, it’s hard to evaluate what those services are worth. It’s a qualitative judgment, which is harder to size up.

So there’s a bias toward basing decision-making on the tangible, highly knowable cost. And buyers will move production for a few pennies a garment because it’s a highly competitive, cost-driven industry. It’s sometimes called “chasing the cheapest needle.”

And you’ll see apparel is a great way for a country to move up the economic ladder, because you can start out making easy-to-produce stuff like T-shirts. It’s very easy to find used sewing equipment [and] low-skill labor, so any underdeveloped country can get started that way.

But then … they move up the ladder…. China was there maybe 20 or 30 years ago, but gradually over time, they’ve moved way up in their skills and sophistication. And with it, wages have moved up, so China’s no longer the dirt-cheap, lowest-cost production site. So what you see happen is companies will move to a much less developed country, maybe Bangladesh … because wage rates are lower [and] you get lower production costs–”chasing the cheapest needle.” So it’s hard to compete on service in a cost-driven industry. That’s one of the challenges that Luen Thai has faced.

Knowledge@Wharton: That’s why the company had a bit of a challenge in store for it when it tried to convince its customers that their model …

Fisher: Yes, they did. They absolutely did. Their concept, I think, makes sense. You look at the costs to design, produce and deliver a garment to the store. Only about a third of that cost is manufacturing cost, and that’s the cost that all the buyers gravitate to. The other two-thirds are soft costs: design, logistics, handling, [and] transportation. So Luen Thai wants to attack that other two-thirds and try to improve on that.

Knowledge@Wharton: Is the model that it has devised being copied by other manufacturers in low-cost countries?

Fisher: I think it’s almost the other way around. In industries like consumer electronics, which have not had the same degree of trade restrictions as apparel has had, they’re much further along in the supply-chain-city concept.

I’d visited Luen Thai in the summer of 2006 and [on] that same visit I spent a day at a Chinese company, Taiwan-based, in the U.S. called Foxconn. In China, they’d be called “Hon Hai.” And I’d not heard of them previously. I was surprised to find out they’re about $32 billion in revenue. They’d be a Fortune 50 company if they were based in the U.S.

They produce all of the branded consumer products. So they produce for
Dell
,
Motorola
and
Apple
–you name it–all the well-known companies. This is one of 12 facilities, and I was struck by the size of it. And I asked somebody how big it was, and they said, “Well, let me put it this way. You came in the front gate, and if you’d started walking from the front gate toward the back gate, it would take you 45 minutes to get there.” So [with] 245,000 employees, [it's] literally a city [with] their own police force, hospital, [and] school.

Knowledge@Wharton: That’s remarkable.

Fisher: It’s remarkable what’s happened. I was truly shocked at the scale of outsourcing, offshoring, the degree to which China has become a juggernaut, almost resembling Japan in its ascendancy in the 1980s.

Knowledge@Wharton: That’s an interesting point. And of course, Japan, which began post-World War II as a low-cost manufacturer, grew its economy tremendously …

Fisher: Yes.

Knowledge@Wharton: And moved out of that bracket to become the world’s second-largest economy. Do you see the same thing happening for China? Are there any differences with the Japan experience? Or is China mostly similar to Japan in the way it’s growing its economy now?

Fisher: That’s a very interesting suggestion. I’m sure there are differences, but I’m struck more by the similarities. It looks very, very similar. Post-World War II Japan was very, very low-cost labor. “Made in Japan” was, at the time, synonymous with low quality. China, in the 1980s, looked the same way. Now, 20 years later, China’s synonymous with high quality, just as Japan became synonymous with high quality. It looks very similar. It’s almost following Japan, 30 years lagged.

And they’re starting to have some of the problems that Japan had as they became more prosperous and it was harder for them to compete at low wages. China’s running into rising cost pressures.

There was a student of mine. His name is Gang Yu [and he] grew up in Wuhan, China, got his Ph.D. at Wharton, taught at the University of Texas for a while, and then left [as] the VP of supply chain at Amazon, and now he runs Asian sourcing for Dell. So I stay in touch with him.

And when I got back [from] this visit to Foxconn, I was truly blown away by what a powerhouse China had become. And he said, “Well, don’t worry too much. We’ve got our problems in China.” And he talked about rising costs [and] lack of labor availability–so it was labor scarcity pushing up costs–[which were] some of the same things that began to afflict the Japanese economy in the early 1990s.

So it will be interesting to see. Maybe “interesting” is too weak a word. It will be highly important to see what is going to happen in China.

Knowledge@Wharton: Well, China of course as you well know has faced a lot of bad publicity here in the U.S. and elsewhere for shoddy products being shipped to the United States, is that a reason for …

Fisher: They are second only to Wal-Mart in the bad press they are getting.

Knowledge@Wharton: Is that a reason for concern on the part of their customers here and elsewhere who might have turned to China in the explosion of outsourcing abroad only to find that there have been some serious drawbacks. I mean how should customers here in the U.S. and Europe and elsewhere think about these problems that China has had with quality?

Fisher: I am not sure whether their quality problems are any more frequent or greater than if those same products, say 40 years ago, were being produced in the United States because there would be quality problems then, too. You may recall there was a big tire recall in the U.S. 10, 20 years ago. So that is kind of point one. I don’t really know the objective facts on whether this speaks to substandard quality coming out of China. It is a different government regulating quality than when you are producing in the U.S. and it was your government, the U.S. government, regulating it. So I guess the phrase, “Trust but verify,” would come to mind.

Knowledge@Wharton: Before we end our conversation, I did want to loop back to something you began discussing in the beginning of our talk which was the tremendous change in outsourcing in the last couple of decades. Do you think that companies in North America and Europe and other developed countries have responded well in seeking out countries like China and India, etc.? Have they mostly done the right thing in finding the right partners to do business with and in approaching that issue in the right way? Are they getting the most benefit from it or are there still areas where there could be some improvement on the way firms in developed countries go about their purchasing and procurement activities abroad?

Fisher: Well obviously, the answer to your question is “yes” and “yes.” It is a complex subject, but on balance I think that they are doing more things right than wrong, but of course there is always room for improvement. Having looked through the 1980s and teaching operations management at Wharton, it was almost like a religion that … “real men” did manufacturing and “real economies” did manufacturing. And so it was troubling to me the idea of hollowing out the U.S. economy.

But if you think it through, all work–this is a slight oversimplification, but not much–.can be divided into muscle work and brain work. And so what we are doing right now talking to each other is mostly brain work. A lot of manufacturing is a blend of the two, but many types of manufacturing are more muscle work than brain work.

So brain work tends to pay better than muscle work. So if an economy wants to ascend, it has to be carefully managed, but it makes sense to offshore and outsource the muscle work to low-wage-rate countries and retain the higher-margin brain work. So in manufacturing product companies, that would include things like market research and product design.

Now that certainly makes sense, but you’d better be very sure that you are excellent at the brain work. It is not enough to say, “We are going to do the product design and marketing and then produce “me-too” products or ho-hum, uninteresting products.” You’ve got to really be world-class at that.

Because these low-cost-labor countries that we are outsourcing to, they want to get into the brain-work game, too. So you see Chinese companies–for example, Foxconn, on their corporate video. They started out in 1970 making TV knobs, if you could believe that, the most pedestrian product you could think of. Now they have gone to making really high-tech stuff, but it is largely based on low-cost labor. They want to get into innovation.

So, it is a little bit like riding a tiger, I think, that in outsourcing to low-labor-cost countries you get a short-term benefit, but there is the risk you may be spawning a competitor.

Knowledge@Wharton: That is an excellent point, and is it one that firms in the U.S. and Europe are going to have to worry about in the next five to 10 years? As you well know, there has been a lot of political consternation over the quote-unquote “loss of jobs” in America to low-cost countries if indeed the brain work, so to speak, is going to be the next challenge to be faced by, say, U.S. firms. Is it a real reason for concern? Could the Chinese and India be critical competitors to U.S. companies in that area?

Fisher: Absolutely they could be. I think the key to a prosperous economy is to compete on things that pay well. Brain work, I think, pays well. I think implicitly or explicitly by outsourcing labor-intensive activities, anything from manufacturing to call centers, to low-labor-cost countries, the U.S. is moving down a path of competing on brain work. But that implies a whole bunch of things. Like you’d better have a very good education system or else segments of society get left behind in the U.S. So there are a lot of challenges I think our economy is facing.

The education systems in foreign countries are quite good. Right now, labor rates are low there. They’re also low for professional services, so you are seeing brain-work-type activities getting outsourced to low-labor-cost countries–not to laborers, but to engineers. So software going to India would be an example.

Knowledge@Wharton: Is there anything in terms of research that you’re working on now that might be pertinent to what we have been talking about? You wrote the case study on Luen Thai, which you shared with us today. Is there anything else that you are working on right now that might be of interest to readers and to follow up on when that project is completed?

Fisher: Right now, and really for the last decade, my research has been focused on retail supply-chain management and I’ve been led to be intrigued with and aware of these global issues because retail supply-chain management has come to mean global supply-chain management. So I haven’t focused explicitly on that in my research, but I was so intrigued with this, I am planning to introduce an MBA minicourse next year on global supply-chain management, almost as a way to launch a next wave of my research on that topic.

There is a joke that the first time a course is taught, the instructor learns. The second time, the students learn. And this is probably overly harsh, but then the third time, nobody learns.